The Carbon Economy

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Hazelwood is the world’s
dirtiest power station. Located near
the vast Latrobe Valley brown coal
deposits in Australia’s Victoria state,
the plant is a magnet for environmental
protesters, angry that its emissions
of greenhouse gases per unit of electricity
topped a recent global ranking
by the World Wildlife Fund.

Hazelwood was scheduled to
close last year. Yet it remains in service
thanks to a pioneering deal
struck in June 2005 between its
owner, London-based International
Power, and the government of Victoria,
allowing the company to keep
the station going—and start a new
open-cut coal mine nearby—as long as it agrees to limit the
plant’s lifetime carbon dioxide emissions to 445m tonnes. Once
emissions reach that limit, the station must close. Currently, it
produces about 17m tonnes a year, which would give it a life of
a little over 26 years.

“There is no question that brown coal from the Latrobe Valley
emits relatively high levels of CO2, [so] we were happy to
make those concessions,” says Mark Williamson, International
Power’s CFO. Agreeing the emissions cap gives the company the
incentive to invest in “clean coal” technology, since extending the
life of the station depends on it, Williamson says.

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Hazelwood is just one of International Power’s 40-plus power
stations in 18 countries being influenced by a new carbon economy.
Williamson says that all investments made by the £2.9 billion
(€4.4 billion) company are now based on the assumption
that environmental compliance costs will increase. That’s already
had an impact—though International Power’s generation capacity
rose by nearly 50% in the past three years, CO2 emissions per
kilowatt-hour fell by 15%.

Nowhere is this new reality more apparent than in Europe,
which accounts for about a third of the company’s generating
capacity. Since the EU launched its CO2 emissions trading
scheme in January 2005, Williamson says that his company
“treats carbon like a fuel when selling forward our output.”

Europe’s “cap and trade” system, which allocates tradable emission
allowances to the EU’s largest emitters, “kick-started the global
carbon market,” boasted Stavros Dimas, the EU’s environment
commissioner, in a speech last summer. When it ratified the Kyoto
protocol in 1997, the EU set itself an ambitious target of reducing
greenhouse gas emissions by 8% from 1990 levels by 2012.

The linchpin of this commitment is the CO2 trading scheme,
which covers around 40% of the EU’s total greenhouse gas emissions.
In 2005, regulators dispensed pollution permits to 11,500
plants in the oil, power, steel, cement, glass, ceramics and paper
sectors. Exceeding permitted levels results in a €40-per-tonne fine
in the first phase, which runs through 2007, though companies
can buy and sell their rights to manage shortfalls and surpluses.
During the second phase, which will run through 2012, a
fresh batch of allocations will be awarded to a wider range of
companies, with additional greenhouse gases, like methane and
nitrous oxide, possibly also included. Penalties in the second
phase will rise to €100 per tonne.

The Power of Carbon

With the power sector accounting for nearly 60% of the EU’s
CO2 scheme, energy companies have been the market’s most
active participants.

Drax has been more active than most. The £929m group
operates the massive 4,000 megawatt power station at Selby, in
northern England, the largest coal-fired plant in Europe, supplying
7% of the UK’s electricity while emitting around 21m
tonnes of CO2 every year. Last year, Drax exceeded its annual
CO2 allowance by 6.3m tonnes, forcing it to buy extra permits in
the market at an average price of £14 per tonne.

As the scheme intended, carbon now factors heavily in the
company’s investment decisions. “Because CO2 now has a price,
we are able to evaluate and make investments that benefit both
the company and the environment,” Drax finance director Gordon
Boyd says. “In the short time that the emissions trading
scheme has been live, we have acquired a lot of knowledge about
its drivers.”

Later this year, Drax’s board will consider the refurbishment
of turbines in its generators, an investment of about £100m over
five years to improve the station’s energy efficiency by 1.5 to 2 percentage points. Though a marginal efficiency gain, it would also
save 1m tonnes of CO2 per year. “It’s an investment we feel more
comfortable making because there is a price for CO2,” Boyd says.
“It will save coal costs, but what makes it more likely than not that
the board will approve the project is that it also saves CO2.”

Carbon limits, even for the heaviest polluters, haven’t hurt
profitability. Drax’s Ebitda surged to £239m in 2005, from £90m
in 2004, and was again £239m in just the first six months of 2006,
compared to £72m in the same period a year earlier. International
Power, meanwhile, saw its European operating profit jump
168% in 2005, rising a further 109% in the first half of 2006.
The sharp hike in profitability came as the cost of CO2
allowances rose exponentially (see “Fizzy” at the end of this article), accompanied by rising oil, gas and coal prices. UK power generators,
with a carbon shortfall of 23% in 2005 (see bottom chart), were the biggest buyers of CO2 allowances in the EU, but were still able to make around €1 billion in profit by feeding carbon prices into electricity prices, according to the Carbon Trust, a British quango.

This windfall angered energy-intensive companies. Alcoa,
the world’s largest aluminium maker, groused recently that the
carbon-fuelled rise in power costs had a “significant impact”
on its operations in Italy and Spain, and forced the closure of
a plant in Germany last year.

However, according to Per-Otto Wold, CEO of Oslo-based
market information provider Point Carbon, some electricity end
users are partly to blame by failing to recognise their own carbon
allocations as an asset. If they had, they could have traded in the
carbon market and reduced electricity prices last year.
There is no shortage of advice about how to leverage carbon
allowances. Roland Geres, Munich-based managing director of
consultancy FutureCamp, says he’s working on projects that use
the sale of CO2 allowances to co-finance technology upgrades
at industrial companies.

The word needs to spread more widely to reap the carbon
benefits. Though a company’s emissions position now has
important financial implications, “the environment guys don’t
speak the same language as the treasury guys,” says Sascha
Lafeld, managing director of Frankfurt-based 3C Climate
Change Consulting, a spin-off from Dresdner Bank. Environment
managers usually run plants to optimise emissions individually,
whereas it often makes more sense to optimise across
a company’s entire European capacity. This is where finance
should step in, Lafeld says: “Finance executives think in a systematic,
strategic way, but they are dependent on timely, relevant
information from the environmental side.”

The Visible Hand

While conceptually straightforward, the CO2 market has been
as subject to wild volatility as any new market.

This was starkly apparent in spring this year, when the CO2
allowance price plunged from above €30 to below €10 over a torrid
two-week period when the official 2005 emissions data for
France, the Netherlands and the Czech Republic leaked nearly
three weeks early, showing an unexpectedly large allocations surplus.
Another leak two weeks later confirmed a surplus of
allowances in most countries.

“It’s fair to say that if this was the stockmarket, people would
have ended up in court,” says one trader at a large European utility.
Further complicating matters is the nature of the product
being traded—”a forced regulatory and political construct that
you can’t easily do fundamental analysis on like other com-
modities,” as the trader describes it. “We don’t know how many
companies will put in the time and effort to trade their credits,
and we assume that a lot of certificates will just expire.” Carbon
allowances are not transferable from the current phase of trading
to the second phase, creating “a strange end effect that no
one fully understands,” the trader says.

This is clear from the confusion in the run-in to phase two of
the scheme. Only Estonia submitted its CO2 allocation plan for
the second phase on time. As the EU—like most individual member
countries—is likely to emit more greenhouse gases than it
committed to under the Kyoto agreement (see charts on this
page), the European Commission reckons that it will need to cut
CO2 allocations by at least 6% in the second phase. Governments,
meanwhile, have so far been pushing for increased allowances. As
analysts at investment bank JPMorgan warned in a June report, a
“pitched battle” between member states and the commission over
allowances is likely to add to the confusion and uncertainty in the
months ahead.

However, “one thing that is certain,” says Michael Rea, director
of strategy for the Carbon Trust, “is that we’re moving into a
carbon-constrained world, and the price of CO2 is likely to be
more than it is today.” Indeed, futures for CO2 credits in 2008,
the first year of the second phase, are trading around 30% higher
than 2006 contracts, suggesting that the commission will be
able to slash governments’ overall carbon allowance plans.

Partly Cloudy

Still, several key questions about the second phase remain
unresolved.

It’s unclear, for example, to what extent countries will distribute
emission allowances by auction—up to a limit of 10%—to mitigate
the windfall profits generated by free allocations in the first
phase of trading. Harmonising permit allocation is another pressing
issue. For instance, new heat and power plants in Germany
receive allowances covering 130% of expected emissions,
compared with just 60% in Sweden, according to the Centre for
European Policy Studies, a Brussels-based think-tank. Whether
countries will continue to base allocations on historical emissions,
thus rewarding environmental laggards, or move towards fuel- or
output-based benchmarking, is also up for debate. Another sore
point: some countries withdraw allocations for plant closures,
encouraging companies to keep dirty plants running.

It’s no wonder that in a February survey of market participants
by Point Carbon, respondents cited political factors as the
most important long-term price driver for the EU’s emissions
trading scheme. These political factors, especially the lack of any
guidance on the fate of the trading scheme after 2012, are, perversely,
hindering investment in environmental efficiency.

“We have capital-intensive assets with very long lives, so we
need reasonable visibility of the future carbon market dynamics,”
notes Williamson of International Power. “What’s needed
is the political will across Europe to create the proper tension in
the market so that it provides a predictable price. We also need
clarity on how this tension will be applied in the long term.”

A post-2012 trading period lasting 10 years or more would
be helpful for investment plans, Williamson says. “At present
we’re not planning to build new plants partly because of the
uncertainty around carbon. There’s no question that this lack of
certainty is slowing down our decision-making processes.”

At Drax, finance director Boyd notes that his company is
focusing on projects with payback periods of less than five years,
keeping them within the limits of the CO2 market’s second
phase. Longer-term projects are approached with caution. For
example, co-firing its station with up to 20% biomass—grasses,
willow, rapeseed and other crops—could, in theory, save Drax
four to five million tonnes of CO2 per year. But investment in
this capability so far has been limited, just enough “to get the
logistics in place,” says Boyd. “We can ramp it up, carrying well
beyond 2012 if the market is right.”

Emission Control

The peculiarities of the carbon market also affect investment
decisions of companies not currently covered by the scheme.
Yara, a NKr45 billion (€5.3 billion) chemicals group based in
Oslo, is one of the world’s largest producers of fertilisers. Some
of its combustion plants fall under the carbon trading scheme,
but their CO2 emissions are already well below the industry
average because “energy efficiency was an issue for us even
before greenhouse gases became a major issue,” says Tore
Jenssen, Yara’s head of health, environment and safety. As a
result, the company was able to sell 100,000 surplus carbon credits
from a plant in the Netherlands last year.

The company is also a big emitter of nitrous oxide, a greenhouse
gas with more than 300 times the global warming
potential of CO2. In October last year, Yara unveiled a groundbreaking
new catalyst technology that dramatically reduces
N2O emissions. If rolled out at all of its nitric acid plants, the
technology would cut Yara’s greenhouse gas emissions by 25%.
It’s already in place at the company’s Norwegian plants, contributing
to compliance with a voluntary emissions reduction
agreement signed by the country’s process industries in 2003.

Looking For Carrots

A Europe-wide rollout will depend on whether N2O is included
in the emissions trading scheme, Jenssen says. “If there are some
carrots, some benefits to adopting new technologies, they will
be adopted much faster,” he says. Countries can choose unilaterally
to include N2O in the second phase of emissions trading,
leading to furious lobbying by the chemicals industry. “We are
not asking to get rich on this, but simply for payback on our
investments and R&D,” Jenssen says. “It would help maintain our
competitive position. Competitors outside of Europe are not
subject to the same restrictions, so emission allowances that are
too low will restrict trade.”

Adding to the complexity, the EU emissions trading scheme
is soon to acquire a global dimension. Pollution permits issued
under a provision of the Kyoto protocol called the Clean
Development Mechanism (CDM), a greenhouse gas reduction
programme administered by the United Nations, will be
exchangeable for EU emission allowances from 2008. CDM
emission credits are awarded for projects that reduce any of the
six main greenhouse gases in developing countries.

In May, International Power spent €12m for a 10% stake in
BioX, a Dutch renewable energy company active in the CDM
market. BioX specialises in converting oil-fired plants to run on
palm oil, a much cleaner fuel that it harvests in southeast Asia.
BioX generates CDM credits by capturing methane from the
palm oil plantations and converting it into electricity used by
processing mills. This provides a “dual benefit” for International
Power, says CFO Williamson, as co-firing its European plants
with palm oil reduces emissions, while the CDM credits can be
exchanged for EU CO2 allowances.

When a Dutch firm runs a project in Malaysia that will help
offset the emissions of a UK-based company, it’s hard not to
argue that it marks the birth of a truly global carbon market.
Some €22 billion of CO2 credits will be traded this year, up
from €9 billion in 2005, according to Point Carbon. As Europe’s
emissions trading scheme matures, imposing increasingly stringent
emission targets on a wider range of industries, the region’s
companies will gain experience of the risks and opportunities created
by carbon constraints. Despite the initial frustration, being
the first movers in the nascent carbon economy could put the
region’s companies at a significant advantage.